Speech
Monetary Policy Regimes: Past and Future

Introduction

It is a pleasure to be speaking at this year's Conference of Economists on a
subject which has been central to my own career. I thought of calling the speech
‘Monetary Regimes I Have Known’, but that would have given too
historical an emphasis. While history is extremely important, and provides
a useful antidote to excessively abstract thinking, more is needed to satisfy
the conference theme of ‘policy challenges of the new century’.
I have therefore attempted to respond in a forward looking way, by drawing
some conclusions about the direction in which monetary policy regimes are likely
to evolve.

Historical Overview

In broad outline, Australia's post-war monetary policy experience has much in
common with that of other countries in the developed world. Certainly the starting
point – a fixed exchange rate under the Bretton Woods System –
was the same, and several of the subsequent phases have been common to a significant
number of countries. We can usefully divide the post-war monetary policy experience
in Australia into four main parts:

the fixed exchange rate period, which lasted until the early 1970s;

a period of monetary targeting between 1976 and 1985;

a transitional period which followed the demise of monetary targeting and lasted
until the early 1990s; and

the inflation targeting regime, in place since around 1993.

While every country has its own particular story to tell, something similar to this
four-part schema, with suitable adjustments as to timing, could probably be
applied to quite a wide range of other countries over the same period. In making
this classification of policy regimes, it is wise to avoid being overly precise
about dates. Sometimes regime shifts are quite dramatic and can be precisely
dated – for example, the ending of US dollar convertibility into gold,
and the United Kingdom's exit from the European Exchange Rate Mechanism
– but this is not invariably the case. In Australia, the movement between
regimes has tended to be evolutionary, and it is not always possible or helpful
to date them precisely.

How did these four regimes perform, and what were the critical factors that led to
the move from each regime to its successor? To answer these questions we need
to have in mind some criteria against which the performance of a monetary policy
regime can be assessed. Most practitioners and theorists would, I think, agree
on two desirable characteristics of a monetary policy regime. First, policy
needs to provide a nominal anchor for the economy: the policy regime must have
the characteristic that it systematically resists excessive inflation or deflation,
and thereby delivers a satisfactory degree of price stability in the long run.
The second objective is to provide a degree of stabilisation in the short to
medium term in response to shocks, which includes resisting adverse shocks
to output and employment. This objective might be met either through the capacity
of a regime to under take deliberate policy responses when shocks occur, or
through automatic stabilisers inherent in the regime.

The Fixed Exchange Rate Period

The longest lasting of the four regimes, by a large margin, was the fixed exchange
rate, also known as the Bretton Woods System, or the gold exchange standard.
At the start of the post-war period, the Australian currency had already been
fixed to sterling at an unchanged rate since 1931. Subsequently, there were
only two major changes to Australia's international parities until the
1970s: the first, in 1949, when Australia followed a sterling devaluation against
gold and the US dollar, and the second, in 1967, when sterling was further
devalued, but Australia did not follow. Thus, Australia's exchange rate
against sterling remained unchanged from 1931 to 1967, while the rate against
the US dollar – which is more important for current purposes –
was unchanged from 1949 to 1971. As was the case for most other countries,
the Bretton Woods System of ‘fixed but adjustable’ exchange rates
was operated in practice in Australia in the 1950s and 1960s as a firm commitment
to fixed parities. The fixed exchange rate was effectively the linchpin of
the monetary policy regime.

While it is not possible to pinpoint an exact date at which this ceased to be the
case, parity adjustments became much more frequent after the next Australian
dollar realignment occurred in 1971. Rather than being the anchor of policy,
the exchange rate henceforward was increasingly viewed as an adjustable policy
instrument. There were six parity changes in the years from 1971 to the adoption
of the crawling peg system in November 1976; and this more flexible system,
in turn, gave way to the float in December 1983. The history can thus be characterised
as involving essentially fixed parities up until 1971, followed by a gradual
transition to greater flexibility and a stronger internal policy focus in the
years that followed.

An important characteristic of a fixed exchange rate system, of course, is that it
provides a nominal anchor, as long as the monetary policy of the country to
which the exchange rate is fixed is itself conducted in a way that is consistent
with reasonable price stability. This was indeed the case for most of the period
up to around 1970. Under the Bretton Woods or gold exchange standard, most
currencies were pegged to the US dollar, whose value was in turn tied to gold.[1]
The central role of the US dollar in the system placed a strong discipline
on the macroeconomic policies of other countries. Unless countries were prepared
to make significant unilateral exchange rate adjustments, which happened only
rarely, their inflation performances in the longer run were effectively determined
by US monetary policy.

As I have argued elsewhere (Macfarlane 1997), this system worked reasonably well
until the second half of the 1960s. The United States for the most part conducted
conservative monetary and fiscal policies that kept budgets close to balance
and inflation low, and this underpinned a period of sustained low inflation
in other countries. In Australia, apart from some periods influenced by sharp
commodity price movements, inflation was generally low and close to US rates
(Graph 1).

Graph 1

This situation began to change from around the mid 1960s. Tax cuts in the 1964 and
1965 budgets, and subsequent increases in defence spending associated with
the Vietnam War, shifted US fiscal policy to an expansionary position. Inflation
began to increase, albeit from very low levels, after about 1965, and balance
of payments deficits run by the United States meant that a number of other
countries began accumulating substantial dollar reserves. This fed the process
of money creation in these countries and relaxed the constraints on their domestic
macroeconomic policies, with the result in many cases that inflation rates
increased. Causes of the eventual breakdown of the Bretton Woods System in
the face of these pressures have been much debated, but the core of most explanations
is that the system lost its capacity to provide effective policy discipline.
This, in turn, reflected the loss of suitability of the US dollar as the system's
nominal anchor, the role it had played so effectively over the two previous
decades.

It is interesting to note that the policy debate in Australia in the 1950s and 1960s
paid little or no explicit attention to the nominal anchoring role of the monetary
regime. That is not because the problem of inflation was thought to be unimportant
– on the contrary, the need to control inflation was well recognised.[2]
Nonetheless the main focus, both of practitioners and of the economics profession
more widely, was on the second of the two roles of monetary policy that I outlined
earlier, namely its role in responding to shorter-term shocks. In fact, many
commentators talked of monetary policy as though it was totally discretionary
and free to pursue whatever domestic objective it thought most worthy (see
next section on Phillips curve).

Perhaps the most important reason for this misapprehension was that the existence
of the long-run anchor was simply taken for granted. Policy did not need to focus on achieving
a good longer-run inflation performance because the fixed exchange rate regime
delivered this result in a semi-automatic fashion. In this environment it was
natural to focus on shorter-term objectives, with the balance of payments serving
as an important barometer of the need for policy action: whenever domestic
demand was too strong, this would quickly show up in a payments deficit which
needed to be corrected by tighter policy, and vice versa.
In this way, the policy regime ensured that actions taken in response to short-term
demand pressures had the effect of consistently tying the economy in to the
long-run anchor.

The eventual failure of the fixed exchange rate system to ensure continued good macroeconomic
performance reflected a combination of circumstances. The expansionary shift
in US policy, to which I have already referred, meant that the external anchor
became increasingly a source of inflationary pressure rather than of price
stability. This was the case not just for Australia, but worldwide. In Australia's
case, however, the effect was amplified in the early 1970s by the related phenomenon
of rising commodity pr ices, which had a disproportionate effect on Australia,
given our high commodity export exposure. The effect was to relax the balance
of payments constraint and allow a further loosening of domestic policy discipline,
with the result that the rise in Australia's inflation rate soon overtook
that in the United States. The role of the 1973 oil shock in all of this was
also important, but it should be remembered that inflation in Australia had
already reached double-digit rates before the oil shock occurred.[3]

The Rise and Fall of the Phillips Curve

The early to mid 1970s was a period of re-evaluation of the earlier conventional
thinking about monetary policy, prompted by the experience of a number of years
of rising inflation. It is interesting to focus on the nature of that re-evaluation
because it remains relevant to policy today.

In the 1960s, the conventional thinking was summed up in the widely influential notion
of a stable downward-sloping Phillips curve. Inflation was thought of in terms
of demand-driven processes that would move the economy along the curve, so
that high levels of demand would produce a combination of high inflation and
low unemployment, and low levels of demand the reverse. The role of policy
was to manage aggregate demand so as to achieve a preferred combination of
outcomes, taking the position of the Phillips curve as given.

Of course, not all economists subscribed to this simplistic world view, but I think
it is a fair representation of the consensus among those economists who were
most influential and among a broad range of other policymakers, politicians
and journalists. There was considerable confidence for a time that policy could
effectively manage the trade-off.[4]
Policy before about 1970 had been quite successful: periods of clearly excessive
inflation had been rare, and were quickly reversed when they occurred. But
there developed a general tendency among policy-makers in the late 1960s and
early 1970s to try to exploit the trade-off to extract more growth, in the
belief that the cost in terms of inflation would not be too great.

The experience of the 1970s – the simultaneous rise in inflation and unemployment,
and their persistence at high levels – proved this understanding of the
economy to be too simplistic and an inadequate guide for policy. To a mindset
based on the stable Phillips curve, the combination of high inflation and high
unemployment could not be readily explained. Indeed, it appeared internally
contradictory, since inflation was thought of as a symptom of excess demand
while high unemployment signalled that demand was deficient.

Two factors needed to be brought into the conventional model in order to understand
the 1970s experience. The first, which had been emphasised both by Friedman
and by Phelps, was the role of expectations. The short-run Phillips curve was
to be thought of not as a permanent trade-off , but as conditional on the expected
rate of inflation. Expansionary demand conditions were associated with higher-than-expected inflation, rather than high inflation per se,
so the trade-off of higher inflation for lower unemployment could only be exploited
over the limited period in which inflation expectations did not fully adjust
to the new higher rate. In the longer run, when expectations had adjusted,
high inflation would have no stimulatory impact. In Friedman's words, ‘a
rising rate of inflation may reduce unemployment, a high rate will not’
(Friedman 1968, p. 11). The operation of this principle had not previously
been observable because inflation had never stayed high for long enough to
be built into expectations.

The second, and related, factor to be brought into the conventional model was the
importance of supply shocks. These could be thought of as shocks which reduced
the sustainable levels of output and employment consistent with steady inflation.
For much of the world the quintessential supply shocks were rises in oil prices
but, for Australia, the real wages shock of 1974 was probably at least as important.
Recognition of the importance of supply shocks implied a corresponding recognition
of the limitations of what could be achieved through conventional demand-management
policies.

Although economic thinking has advanced in a number of ways since the 1970s, these
two basic lessons from the period remain relevant, and often need repeating.
While the economics profession was quick to take up the stable Phillips curve,
it was also quick in dropping it as a policy prescription.[5]
But there are still some in the policy debate – particularly among politicians,
lobbyists and journalists – who think of the economy in terms of a stable
Phillips curve, and who would like us to choose a higher inflation rate on
the assumption that this would produce a sustained lift in growth and employment.
But that is not the choice we face. Higher inflation can deliver at best only
a temporary stimulus to growth and, in the longer run, is more likely to be
detrimental.

The Move to Monetary Targeting

In the light of the early 1970s experience, economists stopped assuming a stable
Phillips curve and started looking for ways to anchor monetary policy decisions.
The Friedman suggestion of a steady growth of the money supply sufficient to
accommodate normal economic growth and low inflation found favour in a number
of countries. Several had been focusing on monetary aggregates since the early
1970s and, by 1975, a number, including the United States, Germany, the United
Kingdom and Switzerland were announcing monetary targets. Australia followed
suit in 1976 by beginning to announce forecasts for the growth of M3. These
were subsequently announced each year in the federal budget until the practice
was discontinued in 1985.

The nature of the targets was somewhat different to what is often assumed in the
textbooks or in the somewhat idealised notions of monetary theorists. In no
country were targets adhered to with the sort of mechanical precision envisaged
in Friedman's
Program for Monetary Stability, the classic statement of the case
for monetary targeting. They were usually seen as guides to policy, and as
vehicles for explaining the rationale of policy actions, rather than being
binding constraints on the policy-maker.

Monetary targeting regimes had a moderate degree of success in achieving their intermediate
monetary objectives, and somewhat greater success in terms of the ultimate
objective of reducing inflation. In the heyday of monetary targeting around
the world, roughly from 1975 to 1985, some substantial reductions in inflation
were achieved. Australia's inflation rate was reduced during this period,
but was still a lot higher than the OECD average by the mid 1980s.

It would be a mistake to attribute the differences in inflation performance across
countries primarily to differing degrees of rigour in the pursuit of monetary
targets. The countries that brought inflation under control most quickly were
not particularly more successful in hitting their monetary targets than the
rest. The general pattern, summarised in Table 1, was that countries achieved
their targets about half the time.[6]
Australia's success rate was a bit less than that, about a third. On another
measure – the average deviation from the target midpoint – Australia's
record was quite similar to that of several other countries.[7]

Table 1: Monetary Targets and Projections

Country

Period

Average absolute deviation from target midpoint

Proportion of years within target range
Per cent

Australia

1977–85

2.6

33.3

Canada

1976–82

1.3

71.4

France

1977–96

2.5

50.0

Germany

1975–96

1.8

54.5

Italy

1975–96

2.7

31.8

Switzerland

1975–96

2.6

47.6

United Kingdom

1976–96

2.7

52.4

United States M2

1975–96

1.5

63.6

United States M3

1975–96

1.8

40.9

Source: Edey (1997)

The achievement of inflation reduction was a product not so much of the technical
merits of monetary targeting as of the general shift in the policy-making consensus
towards inflation control. What was critical was the willingness of the authorities
to run policies that put a consistent downward pressure on inflation over a
period of time. But, that said, the targets did serve a useful purpose. They
focused policy on the need to anchor the nominal magnitudes in the economy,
and they helped in communicating the anti-inflation strategy to the public
and marshalling public acceptance of the required policy actions. The Volcker
disinflation period in the United States was a good example of how useful targets
could be in this role. Alan Blinder described the monetary target as a ‘heat
shield’ which enabled the Fed to maintain a much tougher disinflationary
stance than the public would normally have found acceptable.[8]
As a result the United States was able to make a definitive transition to low
inflation at an early stage.

Monetary targeting was always subject to two well-known problems, both of which were
important in the Australian experience. The first was the problem of controllability.
The fact that targets were often missed was an indication that close control
was either not possible, or would have required undesirable movements in the
policy instruments. The second was the instability of the relationship between
money supply and the ultimate objective of policy such as inflation or nominal
GDP. It was this second problem that was decisive in causing most countries
to abandon monetary targeting as the basis of their monetary policies.

By the mid 1980s, the problem of instability was coming to the fore. The relationship
of money to ultimate objectives had always been imprecise, but had been judged
to be sufficiently stable to serve as a useful guide to policy. But the structural
changes in the financial system that followed deregulation were sufficiently
large that this was no longer the case. In Australia, in the mid 1980s, the
newly deregulated banks were able to win back market share from other institutions,
and the financial system as a whole began to grow more rapidly. To some extent,
this was to be expected, but it meant a lengthy period in which the behaviour
of the monetary and financial aggregates diverged from inflation or nominal
income. In 1985, growth of M3 reached 17.5 per cent, at a time when domestic
inflation had been falling.

The problem was not unique to Australia. By the time our targets were suspended in
February 1985, many other countries had downgraded or abandoned them, for much
the same reasons. In the words of Canadian central bank Governor Bouey, ‘we
didn't abandon the monetary aggregates, they abandoned us’.

The Transitional Period

The move away from monetary targets was followed by a period of transition when policies
became more pragmatic and there was a search for alternative guiding principles.
Once again, Australia's experience was by no means unique. Virtually all
countries were downgrading their monetary targets to one degree or another,
and there was no immediately clear direction as to what should be put in their
place. Theory offered little help.[9]
Some of the alternatives being put up by critics either had already proven unsatisfactory
for us – like a return to fixed exchange rates or forms of monetary targeting
– or were unrealistically radical.[10]
Most countries with floating exchange rates developed a pragmatic approach that,
broadly speaking, tried to resist excessive inflation and to have some stabilising
influence on economic activity in response to shorter-term shocks.

Policy in Australia through this transitional period has been criticised for lacking
a clear conceptual framework and allowing too much scope for central bank discretion,
and there is some validity in these criticisms. In Australia, the policy ‘checklist’,
which entered the discussion for a few years following the abandonment of monetary
targets, comprised a wide range of variables which were to be consulted in
assessing economic conditions and making policy decisions. The list of variables
included interest rates, the exchange rate, the monetary aggregates, inflation,
the external accounts, asset prices and the general economic outlook –
in short, an amalgam of instruments, intermediate and final policy objectives,
and general macroeconomic indicators. The checklist conveyed the idea –
sensible as far as it goes – that policy needs to look at all relevant
information. What was missing was some framework for evaluating that information
and converting it into an operational guide for policy.

Another way of expressing this is to say that monetary policy needed a ‘nominal
anchor’. Pure pragmatism was not enough because it could lead to monetary
policy aiming to achieve a desired result for a ‘real variable’,
which in the long run would be self-defeating. For example, if monetary policy
was solely designed to achieve a given unemployment rate (as to some extent
it was in the late 1960s/ early 1970s in many countries), it would be continually
eased whilever the actual unemployment rate was above the desired rate. But
if the desired rate was too ambitious, this would be a recipe for continued
easing and, in time, continuously rising inflation. At the same time, there
would be no guarantee that monetary policy alone would be able to achieve the
desired unemployment rate if structural factors were important. Similarly,
indeterminacy would arise if monetary policy was directed at the current account
of the balance of payments, as a lot of discussion in the late 1980s seemed
to suggest. If the current account was too large, should monetary policy be
tightened to reduce domestic demand (and imports), or should it be loosened
to lower the exchange rate and hence increase competitiveness?

These sorts of discussion led policy-makers and academics to again ask the question
about what monetary policy can achieve in the long run. The nearly unanimous
answer was that it could achieve a desired rate of inflation, but could not,
of itself, achieve desired outcomes for real variables like the unemployment
rate, the rate of growth, or variables like the balance of payments. Monetary
policy can have an influence for good or bad on real variables, particularly
in the short run, but it was not appropriate to target it at these variables.
As a long-run target, what was needed was a nominal variable like inflation,
nominal GDP or the money supply.

With the money demand function recognised as being unstable, and nominal GDP being
too abstract a concept for easy public perception, attention turned to monetary
policy regimes that centred on inflation. Two main alternatives presented themselves:

a system where the instrument of monetary policy was operated to achieve a desired
result for inflation, without the need for an intermediate target; or

a system where the exchange rate was fixed to that of another country which had a
good record of maintaining low inflation.

In short, the two alternatives which satisfied the condition of providing a ‘nominal
anchor’ were inflation targeting or fixing the exchange rate (sometimes
called the hard currency option). Australia went down the first path, while
most of Europe (including the United Kingdom for a time) went down the second
path by tying their currencies to the Deutschemark.

Some would argue that this two-way classification of the options is too narrow and
that monetary targeting remains a viable third option, at least for some countries.
Germany is often cited as an example. This view ignores the reality that the
Bundesbank has moved a long way away from strict monetary targeting in recent
years, as is evident from the way they move their policy instrument. There
is evidence to suggest that prospective inflationary developments are more
likely to trigger a monetary policy move than is a deviation of money supply
from its target.[11]

Inflation Targeting

Unlike the experience in some other countries like the United Kingdom or New Zealand,
where inflation targets came into force in dramatic regime shifts, the elements
of Australia's inflation-targeting regime were put in place gradually.
There were a number of reasons for this. While inflation targets had considerable
conceptual appeal, the models adopted in the pioneering countries – New
Zealand and Canada – seemed to us excessively rigid with their narrow
bands and low target midpoints. The fact that these were the only working models
available at the time tended to polarise debate, and it took some time for
the Bank to develop its own more flexible version. Also important was the need
to build public support, including political support, for a target, and again
this happened gradually rather than in a single, decisive act.

Some of the key elements of the inflation-targeting approach were in place quite
early. The conceptual basis of such an approach, with a focus on inflation
as the policy objective, no intermediate objective, interest rates as the instrument,
and a transmission process that works via the effect of interest rates on private
demand, had been analysed in a number of pieces that the Bank published in
1989, including its conference volume.[12]
What we now consider one of the key elements of the policy framework, the explicit
announcements of cash rate changes, with explanations of the reasons for each
change, began in January 1990. Over time, the Bank's published commentaries
on monetary policy and the economy became more detailed and developed a stronger
inflation focus. The numerical objective of 2–3 per cent inflation began
appearing in public statements by Governor Fraser in 1992 and 1993. The cumulative
effect of all these developments was to establish an inflation-targeting regime
broadly comparable to those being developed in a number of other countries
around the same time. While there was no individual decisive event, international
comparative tables such as those published by the BIS date the change in Australia
from 1993.[13]

A final element was added with the joint statement on the conduct of monetary policy,
made by myself and the Treasurer on my appointment as Governor. The statement
gave the Government's formal endorsement to the independence of the Reserve
Bank as contained in its Act and to the 2–3 per cent target. It also
provided for enhanced accountability through semi-annual statements and parliamentary
appearances.

Several other countries adopted inflation targets around the same time as Australia.
A recent survey by the BIS counts seven inflation targeters, making this currently
the most numerically popular regime among medium-sized OECD countries (Table 2).
As had been the case with previous regime changes, the immediate reason for
change in many cases was either a breakdown of a previous regime or dissatisfaction
with its performance. In the United Kingdom, Sweden and Finland, the trigger
was the collapse of fixed exchange rate commitments in 1992. New Zealand and
Canada adopted their targets in a deliberate strategy of inflation reduction.
Australia was somewhat different in that there was no crisis that needed to
be responded to, and the target was developed to cement in place an inflation
reduction that had already been achieved.

Table 2: Inflation Targets

Country

Target adopted

Current target
Per cent

New Zealand

Mar 1990

0–3

Canada Feb

Feb 1991

1–3

United Kingdom

Oct 1992

2½

Sweden

Jan 1993

1–3

Finland

Feb 1993

2

Australia

1993

2–3

Spain

Summer 1994

0–3

Source: BIS 1996 Annual Report, updated to incorporate recent changes to targets
in the United Kingdom and New Zealand

The move to inflation targeting completed a significant conceptual leap from the
regimes that had prevailed in the earlier decades. Instead of a focus on intermediate objectives, like the exchange rate or the money supply,
the operational framework of policy was now built around a final objective,
inflation. In describing inflation as the final objective in this context,
I should make clear that inflation control is viewed as a means to an end rather
than an end in itself. The reason monetary regimes have been set up to aim
for low inflation is that this is the best contribution monetary policy can
make in the longer run to growth in output, employment and living standards.

In principle, this approach re-establishes a clear nominal anchor while avoiding
the main problem of the intermediate-targeting regimes – namely, that
the target variables did not have a sufficiently stable relationship with the
final objectives. The approach also preserves, from the transitional period
that I described earlier, the commonsense notion of using all relevant information:
the difference is that there is now a clear criterion – the impact on
the inflation outlook – for assessing what the information means for
policy.

Another property of inflation targets, not always well-recognised, is that they provide
scope for counter-cyclical action. This is automatically built into the policy
framework if a central bank takes seriously, as we do, both the upper and lower
bounds of the target. When the inflation forecast is above the target, the
framework requires policy to be tightened, as was the case a couple of years
ago, and when it is below target, policy has to be more expansionary, as at
present. In this way the policy framework incorporates a systematic resistance
to cyclical demand pressures. I have described this previously by saying that
the policy aims to allow the economy to grow as fast as possible, consistent
with low inflation, but no faster.

Aside from these operational characteristics, an important dimension of the economic
rationale for inflation targets is their role as a discipline on the policy
process. The academic literature lays great store on this – particularly
in the time inconsistency literature – although it tends to focus rather
too narrowly on the idea of constraining the policy-makers. The targets are
seen as correcting an inflationary bias that would otherwise arise from the
temptation of central bankers to go for short-term expansion. In this literature,
rule-based regimes are said to be superior to discretion because they allow
pre-commitment to noninflationary policies, and thereby overcome the assumed
short-termism of the policy-makers. Central bankers are very sceptical of this
line of analysis because we do not see ourselves as inherently inflation-prone.[14]

But while I think this particular argument for a rule-based approach somewhat misses
the point, the ability to specify policy in terms of a relatively simple rule
does have some important advantages. In particular, simple rules provide a
ready vehicle for accountability and for public communication: they require
policy actions to be explained in terms of a clear target, and they help central
banks to resist calls for excessively expansionary policies. Also important
is that, over time, a simple rule like an inflation target can provide a focal
point for inflation expectations by making clear what the central bank is aiming
at.

One of the reasons that inflation targets have proven attractive to so many countries
is that they seem to strike a workable balance, between having these advantages
of a simple rule, and retaining a necessary degree of flexibility. The framework
has simplicity in terms of an easily communicated objective, at the same time
as having flexibility in the interpretation of information and operation of
the policy instrument – a combination of characteristics that Mishkin
refers to as ‘constrained discretion’ (Mishkin 1997).

While the essential characteristics of inflation targets are common to all the practitioners,
there are some interesting variations across countries in the detailed design
features. These involve characteristics like the target midpoint, the width
of fluctuation bands and the timeframe for evaluating performance. Australia's
system differs from the early models (particularly New Zealand) by focusing
on a midpoint of 2–3 per cent (which really means ‘about 2½’)
rather than a range. The most common target midpoint is 2 per cent: Australia
and the United Kingdom are slightly higher at 2½ and New Zealand lower
at 1½ (having originally been at 1). There is also a difference concerning
the meaning of the upper and lower bounds. In the original New Zealand and
Canadian models, inflation was meant to be always within the band, but in our
variation that was never the intention.

At this level of detail there is no single consensus model as to how an inflation
target should be designed. To some extent, the variations reflect the different
historical circumstances of each country. For example, New Zealand, which had
the first and the most tightly specified system, also had one of the poorest
track records on inflation and therefore the clearest need to signal a regime
shift. Notwithstanding these differences, the essentials – a numerically
specified target linked to procedures of public explanation and accountability
– are common to all the inflation targets.

The Future

To the best of my knowledge, inflation targeting was not seriously canvassed as a
monetary policy option until the 1980s. By the end of that decade, however,
as I have described earlier, there were only two monetary policy regimes that
held out the promise of being achievable and of providing a nominal anchor
– the first was the hard currency option and the second was an inflation
target. It is my view that, as we approach the next century, the field will
narrow further, and that inflation targeting will become the dominant monetary
policy regime. This would be a remarkable change for a system that was virtually
unheard of until the second half of the 1980s.

The reason for this change is that the biggest group of countries that have chosen
the hard currency option – the members of the European Monetary System
(EMS) – are scheduled on 1 January 1999 to achieve monetary union. On
that date, there will be one European currency – the Euro – and
one European Central Bank – the ECB. What will be the monetary policy
regime pursued by the ECB? It cannot be the hard currency option because the
Euro will be a floating currency. My guess is that, whatever the ECB chooses,
it will rather closely resemble inflation targeting. An alternative view is
that in order to impress markets that the Euro is as sound as the Deutschemark,
the ECB may follow something akin to the German practice of monetary targeting.
As I said earlier, this would not alter the picture very much as current German
practice seems to be at least as much like inflation targeting as it is like
monetary targeting.

In this new world, there will be three major currencies, which will float against
each other – the US dollar, the yen and the Euro. Of course, none of
these are in the group of countries that has an explicit inflation target,
but I have argued elsewhere that if you had to fit the United States into one
or the other of the formal monetary policy regimes, the one that comes closest
is inflation targeting. The target is not explicit, but the Fed makes no secret
of the fact that it is its assessment of inflationary pressures and the outlook
for inflation that is the major determinant of whether US monetary policy is
adjusted.[15]
The Fed's behaviour over the last month has made that abundantly clear. Japan
is a more difficult case to classify, but the evidence is that with inflation
virtually non-existent, interest rates have been reduced to about the lowest
conceivable level (the cash rate is ½ per cent).

Thus, among the traditional OECD countries, we have a group of explicit inflation
targeters and another group – the big three – who have systems
which could most appropriately be called implicit inflation targeters. Outside
the OECD area, there is still room for countries to choose the hard currency
option – Hong Kong for the past 13 years and Argentina (for a considerably
shorter time) – fit this description. But recent events in Asia as well
as in other regions such as Eastern Europe may have made the fixed exchange
rate option less attractive.

If we take an even longer sweep of history, we can see that we entered this century
with the most irrevocably fixed exchange rate system yet devised, namely the
gold standard. As we enter the next century, we enter a world where floating
exchange rates are the norm, and where the role of nominal anchor will be predominantly
played by an inflation target, whether it is explicit, much as our own, or
implicit as is the case in the United States.

Endnotes

Under this system, the US government agreed to exchange US dollars for gold at $35
per ounce with other governments. Individuals did not have the same rights
and, in fact, were prohibited from holding monetary gold in many countries,
including Australia.
[1]

A good example is Coombs' 1959 speech on the problem of creeping inflation.
[2]

The first OPEC price increase was in October 1973. Over the year to the September
quarter 1973, the increase in the CPI in Australia was 10.4 per cent. Inflation
rates in other countries had also risen well above 1960s levels by then,
reaching 6.9 per cent in the United States, 12.6 per cent in Japan, 6.9 per
cent in Germany and 9.2 per cent in the United Kingdom.
[3]

Many economists thought that the conventionally defined business cycle had become
extinct. See, for example, Zarnowitz (1972).
[4]

Japan, which is excluded from the table, had a much higher success rate, but only
because the targets (or really forecasts) were not announced until roughly
three-quarters of the way through the year to which they applied.
[6]

Excluding the massive overshoot in the year when targets were finally abandoned,
the average absolute deviation from the midpoint was just under two percentage
points.
[7]

Blinder (1987, p. 77). As Goodhart put it, ‘central banks appreciated the function
of a monetary target in providing them with a “place to stand“
in warding off calls for a premature easing of policy’ (1989, p. 296).
[8]

Goodhart (1989), for example, wrote of the ‘increasing divide between a state-of-the-art
macro theory and practical policy analysis’.
[9]

Among the latter were proposals for strict monetary-base control, a currency board,
and radical schemes for a commodity-linked currency or competing privately
issued monies.
[10]

This has been observed by practitioners for years and is now being incorporated into
the literature. See Clarida and Gertler (1996), Mishkin and Posen (1997),
Bernanke and Mishkin (1997) and Laubach and Posen (1997).
[11]